Topic 5: Economic and Financial Analysis of the Company
Chapter 9 (excluding point 9.3)
Types of Analysis:
Structural Analysis
Statement of Source and Application of Funds
Financial Ratios
The information contained in accounting documents, primarily the Balance Sheet and
the Income Statement, allows for conducting an economic and financial analysis of the
company. This analysis helps internal and external users better understand the
company's performance, aiding in management and investment decision-making.
1. Company Valuation: Structural Analysis
Structural analysis can be conducted in the following ways:
a) Horizontal Analysis: Comparing several years through horizontal
percentages, which shows the creation of value in the company.
b) Vertical Analysis: For a single year, using vertical percentages to analyze the
distribution of value within the company.
c) Combination of Both: The integration of horizontal and vertical analyses to
track the evolution of the distribution of the company's value.
Creation of Value in the Company: Horizontal Percentages
Once a base year is selected, all elements in the balance sheet and the income
statement are assigned a reference value of 100%. The data from subsequent periods
are then compared with those from the reference period.
These horizontal percentages allow the company to analyze trends and observe its
trajectory over time.
Example of Horizontal Analysis:
Year X (Income Statement and Balance Sheet): 100%
Year X+1: 115%
Year X+2: 90%
This results in a 15% increase and a 10% decrease, respectively.
Balance Sheet Example (Horizontal Percentages)
Asset 2004 (€) 2004 (%) 2005 (€) 2005 (%)
Intangible Assets 3,000 100 3,500 116.67
Asset 2004 (€) 2004 (%) 2005 (€) 2005 (%)
Tangible Assets 20,000 100 20,500 102.50
Non-current Assets 23,000 100 24,000 104.35
Inventories 2,000 100 1,500 75.00
Receivables 4,000 100 4,000 100.00
Cash and Cash Equivalents 3,000 100 4,500 150.00
Current Assets 9,000 100 10,000 111.11
Total Assets 32,000 100 34,000 106.25
Equity + Liabilities
Item 2004 (€) 2004 (%) 2005 (€) 2005 (%)
Equity 15,000 100 16,000 106.67
Non-current Liabilities 7,000 100 10,000 142.86
Current Liabilities 10,000 100 8,000 80.00
Total Equity + Liabilities 32,000 100 34,000 106.25
Note: The analysis and conclusions are discussed in class and are also available in the
textbook.
Distribution of Value within the Company: Vertical Percentages
The vertical analysis evaluates the balance sheet and the income statement of a
particular period to determine if there is a balance between the various assets and
liabilities within the company. It is a static analysis that measures the relationship
between assets and liabilities or expenses and revenues as they appear at the end of
the fiscal year.
Example of Vertical Analysis (Balance Sheet, 2005):
Asset 2005 (€) 2005 (%)
Intangible Assets 3,500 10.29
Tangible Assets 20,500 60.29
Non-current Assets 24,000 70.59
Inventories 1,500 4.41
Receivables 4,000 11.76
Cash and Cash Equivalents 4,500 13.24
Current Assets 10,000 29.41
Total Assets 34,000 100.00
Equity + Liabilities
Item 2005 (€) 2005 (%)
Equity 16,000 47.06
Non-current Liabilities 10,000 29.41
Item 2005 (€) 2005 (%)
Current Liabilities 8,000 23.53
Total Equity + Liabilities 34,000 100.00
Note: The analysis and conclusions are discussed in class and are also available in the
textbook.
Evolution of the Distribution of Value within the Company
Since the horizontal and vertical analyses are complementary studies, it is advisable
to combine the results of both. You can analyze the evolution of the distribution of
value in:
Assets and their components
Liabilities and their components
Expenses
Revenues
Results
It is recommended to represent these values in graphs (see textbook, section 9.1.3) if
you are analyzing more than two years, which is generally the best practice.
Example of Evolution of Value Distribution in the Balance Sheet (2004 and 2005):
Item 2004 (€) 2004 (%) 2005 (€) 2005 (%)
Intangible Assets 3,000 9.38 3,500 10.29
Tangible Assets 20,000 62.50 20,500 60.29
Non-current Assets 23,000 71.88 24,000 70.59
Inventories 2,000 6.25 1,500 4.41
Receivables 4,000 12.50 4,000 11.76
Cash and Cash Equivalents 3,000 9.38 4,500 13.24
Current Assets 9,000 28.13 10,000 29.41
Total Assets 32,000 100 34,000 100
Equity + Liabilities
Item 2004 (€) 2004 (%) 2005 (€) 2005 (%)
Equity 15,000 46.88 16,000 47.06
Non-current Liabilities 7,000 21.88 10,000 29.41
Current Liabilities 10,000 31.25 8,000 23.53
Total Equity + Liabilities 32,000 100 34,000 100
Note: The analysis and conclusions are discussed in class and are also available in the
textbook.
Statement of Source and Application of Funds (EOAF)
This is a dynamic examination of the company’s assets that explains why changes
occur between the elements of the balance sheet over various periods.
Increases in assets (e.g., buying machinery) or decreases in liabilities (e.g.,
reducing debt) indicate an application of funds.
Decreases in assets (e.g., selling machinery, reducing rights) or increases in
liabilities (e.g., increasing equity, long-term debt, or accounts payable) indicate
an origin of funds.
Example:
Balance Item 2004 (€) 2005 (€) Application (€) Origin (€)
Intangible Assets 3,000 3,500 500 -
Tangible Assets 20,000 20,500 500 -
Inventories 2,000 1,500 500 -
Receivables 4,000 4,000 - -
Cash and Cash Equivalents 3,000 4,500 - 1,500
Equity 15,000 16,000 - 1,000
Non-current Liabilities 7,000 10,000 - 3,000
Current Liabilities 10,000 8,000 2,000 -
Total | 4,500 | 4,500 |
Note: The analysis and conclusions are discussed in class and are also available in the
textbook.
2. Financial Statement Analysis: Introduction
This section combines all elements of the balance sheet and the income statement to
obtain figures that allow us to assess the economic and financial health of the company.
A good starting point is to analyze the balance between current liabilities and
current assets, which is crucial for the company. This is known as working
capital or working capital management.
The next step is to perform financial analysis using ratios.
2.1. Working Capital and the Financial Cycle
1. Long-term or Capital Cycle: The resources invested in non-current assets are
recovered over their useful life through depreciation.
2. Short-term or Operating Cycle: The resources invested in current assets are
recovered much more quickly through sales.
Depreciation: It refers to the annual reduction in the value of a fixed asset.
Depreciation accounts for:
Usage of the assets
Time passage
Technological obsolescence
Depreciation is a cost of production that reflects the annual consumption of non-
current assets. It also allows the company to recover the investments made.
For instance, straight-line depreciation assumes constant annual charges:
Annual Depreciation = (Purchase Value - Residual Value) / Useful Life
Cash, Inventories, and Receivables in the Operating Cycle
The operating cycle focuses on the recovery of funds invested in current assets
through sales. The time required to turn these assets into cash is known as the Average
Collection Period (ACP), which measures the number of days needed to convert a
monetary unit into liquidity within the company's operating cycle.
Inventories (Raw Materials, Finished Products)
Receivables (Clients)
Cash
2.2. Financial Analysis: Working Capital
The company’s working capital is the difference between current assets (CA) and
current liabilities (CL):
Working Capital (WC) = Current Assets (CA) - Current Liabilities (CL)
This value shows the company's ability to cover its short-term obligations. There are
three possible outcomes:
WC > 0: This means that current assets exceed current liabilities, indicating that
the company has enough resources to cover its short-term debts.
WC = 0: Current assets are exactly equal to current liabilities, indicating a
neutral position.
WC < 0: This means current liabilities exceed current assets, signaling potential
liquidity problems for the company.
Example: Working Capital Calculation (2005)
Item Value (€)
Current Assets (CA) 10,000
Current Liabilities (CL) 8,000
Working Capital (WC) 2,000
Thus, WC is positive, indicating a sound balance between investments and financing.
2.3. Financial Ratio Analysis
Financial ratios are proportions or ratios between different balance sheet and income
statement items that provide useful information for decision-making.
The value of this information is greater if we compare ratios over time or against
competitors or industry averages. The most common categories of financial ratios are:
2.3.1. Solvency Ratios:
These ratios estimate the company’s risk both in the short term and long term:
1. Short-term Liquidity Ratio (Current Ratio): This measures the company’s
ability to cover its short-term liabilities with its short-term assets.
Current Ratio = Current Assets / Current Liabilities
Example:
Current Ratio = 10,000 / 8,000 = 1.25
This indicates that the company has 1.25 times the amount of current assets needed to
cover its current liabilities.
2. Long-term Solvency Ratio (Leverage Ratio): This assesses the company’s
long-term financial stability by measuring its degree of indebtedness.
Leverage Ratio = Equity / Liabilities
Example:
Leverage Ratio = 16,000 / 18,000 = 0.89
This ratio implies that the company has almost equal equity and liabilities, indicating a
moderate level of leverage.
2.3.2. Profitability Ratios:
These ratios measure the company’s ability to generate profit, focusing on economic
profitability and financial profitability.
1. Economic Profitability (Return on Assets - ROA): This measures the
company's ability to generate profits from its total assets, regardless of
financing.
ROA = EBIT / Total Assets
Where EBIT refers to Earnings Before Interest and Taxes.
Sales Margin (m): Represents the economic benefit per euro sold.
Sales Margin = EBIT / Sales
Asset Turnover (r): Represents the sales generated per euro invested.
Asset Turnover = Sales / Total Assets
Thus, ROA can be calculated as:
ROA = Sales Margin * Asset Turnover
Example:
ROA = 10,000 / 34,000 = 0.29 (29%)
This indicates that the company generates 29% profit from its assets.
2. Financial Profitability (Return on Equity - ROE): This measures the return
generated for shareholders, focusing on net income in relation to equity.
ROE = Net Income / Equity
Example:
ROE = 6,650 / 16,000 = 0.4156 (41.56%)
Income Statement Example (20XY):
Item Amount (€)
Sales Revenue 35,500
Service Revenue 500
Operating Income 36,000
Wages and Salaries 22,000
Item Amount (€)
Raw Materials Purchases 4,000
Operating Expenses 26,000
Operating Profit (EBIT) 10,000
Financial Income 100
Financial Expenses 600
Net Financial Result (500)
Income Before Taxes 9,500
Assuming a 30% tax rate, Net Income would be:
Net Income = 9,500 * (1 - 0.30) = 6,650
3. Conclusion from the Economic and Financial Information
Although the information obtained from the company’s financial statements is useful, it
is essential to compare it with other companies in the same sector or of similar size to
form a more realistic assessment of the company's position. Additionally, external
factors, such as the general economic environment and specific industry conditions,
must also be considered.